The trade war between the United States and China and the recent freezing of much of Russia’s official foreign exchange reserves have again raised fears of an exodus from the dollar. But nobody should write the greenback obituary yet.
LONDON – The freezing of much of Russia’s official foreign reserves has inevitably led some to predict the imminent demise of the dollar’s “exorbitant privilege” as the world’s preferred reserve currency. But we shouldn’t write the dollar’s obituary just yet.
By itself, the sanction of Russia’s reserves is likely to reinforce the primacy of the dollar as the backbone of the fiat currency system. Only if the United States regularly used such financial sanctions as an offensive foreign policy weapon could a more rapid erosion in the status of the dollar occur.
It is true that, in the last four years, a period marked by the trade war between the United States and China and the Covid-19 pandemic, the dollar has accounted for only 40% of the accumulation of new reserves, compared to 23 % of the euro. The Chinese renminbi’s share of new reserves has risen to 10%, while the Japanese yen and British pound have also gained ground.
Despite this, it is by no means clear that confidence in the dollar is flagging. First, global reserve growth over the past four years was a fraction of the rapid growth seen in the five years before and after the 2008 global financial crisis, reflecting narrowing global imbalances.
The dollar’s share of reserves has fallen from 73% in 2001 to 59% last year. But most of this decline took place in the 2000s, when reserves increased by $8.1 trillion (compared with $2.6 trillion in the last decade).
Second, the International Monetary Fund’s new allocation last year of $650 billion in special drawing rights (SDRs, the IMF’s reserve asset) artificially deflated the dollar’s share of global reserve growth during the pandemic. . SDRs are based on a basket of currencies in which the dollar’s share is only 42%, while those of the euro, renminbi, yen and pound are 31%, 11%, 8% and 8%, respectively. Since SDRs are accumulated primarily in advanced economies that never use them, these stocks effectively inflate non-dollar foreign exchange reserve stocks.
Finally, countries with strong security relationships with the United States, including the vast majority of states with the largest foreign exchange reserve holdings, tend to hold a higher-than-average share of their reserves in dollars. As long as America’s Asian and European allies view US security assurances as credible, these countries have little incentive to move away from the dollar.
Reserve freezes are not new, but the measures against Russia mark the first time they have been applied to a G20 country with a high degree of global trade and financial integration. For foreign investors, reserve freezes aimed at creating a financial panic pose an existential threat, in terms of the possibility of capital being lost or trapped in the ground.
The potency of the sanctions imposed on Russia’s stockpiles came not just from the actions of the United States, but from concordant steps taken by Europe and Japan. Their turnout ensured near de facto unanimity, as Chinese banks were reluctant to deal with Russia for fear of being sanctioned in turn.
But for now, the sanctions risk premium on foreign exchange reserves realistically applies only to countries at high risk of globally coordinated action, namely China. For the vast majority of other countries, the risk of sanctions should remain low. Reserve diversification will continue to make sense, but is likely to benefit the currencies of countries that are considered “remote sanctions”.
And while the US trade war with China and Russia’s stock freeze have again raised fears of an exodus from the dollar, the question is “where to”? Strong network effects underpin the dollar’s “exorbitant privilege,” and Russia’s sanctions have arguably reinforced its anchor status. All things considered, a reserve split 60/40 between the dollar and other currencies seems appropriate.
While the renminbi should continue to benefit from China’s strong trade links with smaller and commodity-exporting countries, its challenge to the dollar is likely to suffer from increased uncertainty regarding the rule of law and the risk premium from sanctions. Larger central banks may be more reluctant to hold renminbi due to the risk of Western sanctions and the corresponding risk of China being forced to re-impose capital controls on foreigners. Therefore, the Chinese currency should remain a fractional part of world reserves.
The euro’s share of world reserves should recover if yields return to positive territory. Recent progress in reducing the risk of a eurozone breakup is the precondition for both higher rates and a larger share of global reserves. However, Europe still needs to address the problems that kept the euro’s share of reserves below 30% before the eurozone crisis: fragmented domestic capital markets and flawed countercyclical stabilization mechanisms.
Other countries have some risk diversification value. But both individually and collectively they are too small to offer a credible alternative to the US, China and Europe as a booking destination.
That said, one can expect lingering consequences from Russia’s stockpile freeze. China will seek to insulate its existing stockpiles from potential sanctions. Commodity exporters will consider how to invest newly minted foreign exchange reserves stemming from the current commodity boom. And foreign investors, both public and private, will assess the possible collateral damage of financial sanctions that could affect the convertibility of renminbi assets in the country.
What could eventually change the dollar’s continued dominance? If history were to rhyme with the UK experience of a century ago, it would involve a combination of US financial sanctions overreaching, further economic stagnation at home, and an erosion of credible security guarantees abroad. Such a scenario seems less remote than it did five years ago. But don’t bet it will happen soon.
The author
Global Strategist at PIMCO, he is a Senior Visiting Fellow at the London School of Economics.
Copyright: Project Syndicate 1995 – 2022